The JOBS Act Turns Five, Regulation A+ Turns Two, Regulation Crowdfunding Turns One: What Should Be Next on the SEC Chair Jay Clayton’s Agenda

With the Jumpstart Our Business Startups (JOBS) Act having just reached its five year milestone, Regulation Crowdfunding hitting its one year milestone, and the two year anniversary of Regulation A(+) fast approaching, I thought this would be a good time to (briefly) reflect on the past, and to focus on the future – of our capital markets for startups and smaller emerging business.

Some Things Never Change, Some Things Have Changed – and Some Things Need to Change

Some Things Never Change

In the “some things never change” department:  the “on again – off again” marriage of two prominent equity crowdfunding advocacy groups, CfIRA and the CfPA, still graces the headlines.  As one who has both called for a unified trade association and served a brief stint as President of the Crowdfunding Professional Association (CfPA) in 2015, a single unified voice for stakeholders in this post-JOBS Act world would be more than welcome.  So I am still hoping for a “wedding invitation.”

Some Things Have Changed

In the “some things have changed” department, most notable for me has been the enactment of what I have referred to as the missing Title of the JOBS Act – the creation of an independent office at the SEC tasked with the single mission of advocating for the interests of small business capital formation – reporting to all five SEC Commissioners – and to Congress.  This quietly became law in December 2016.

To my knowledge I was the first person to publicly advocate for the need for such an independent office at the SEC, back in February 2014, on the pages of Crowdfund Insider.  The rest is history.

In September 2014, former SEC Commissioner Daniel Gallagher, and staunch small business advocate, in presenting his wish list for small business regulatory reforms at The Heritage Foundation, put this issue front and center on the national stage.  Shortly thereafter, the Small Business-Investor Alliance, under the guidance of its then General Counsel, Chris Hayes, took the bull by the horns, and was instrumental in initiating draft legislation, which ultimately became HR 3784 in 2015, and was passed into law in December 2016, entitled “The SEC Small Business Advocate Act of 2016.”

Though characterized (and opposed) by NASAA in legislative hearings as creating an unnecessary government funded internal lobby group at the SEC, remarkably it passed the House Financial Services Committee, the House of Representatives and the Senate unanimously, as a stand alone bill. It was the last order of business of a lame duck Senate in the wee hours on a Friday night in December 2016, and was promptly signed into law by President Obama, sans the Rose Garden signing ceremony.  And the ink had hardly dried when in February 2017 then acting SEC Chair Michael Piwowar publicly signaled that setting up this new office would be an SEC priority in 2017 – a tad faster than its sibling, the SEC Office of Investor Advocate, a Dodd-Frank footnote, which took nearly three years for the SEC to implement.

Some Things Need to Change

In the “some things need to change” department there is, to be sure, a lengthy list.  This article, however, focuses on two issues: one addressing a fix to one of the unintended consequences of SEC rulemaking; the other a simple fix to help jumpstart what I perceive to be a rather lackluster Regulation A+ market thus far.

Regulation Crowdfunding (CF) and the Proliferation of “SAFE” Securities – An Unintended Consequence of SEC Rulemaking

One of the more striking and unexpected statistics measuring the Regulation Crowdfunding marketplace surfaced in February 2017, courtesy of DERA, the analytical arm of the SEC. A  DERA Report compiling data on the types of securities offered by Regulation CF, DERA reported that 26% of the securities offered were “SAFES,” an acronym for Simple Agreement for Future Equity.  If the truth be known, most securities lawyers, let alone investors, have never heard of a SAFE – and few lawyers could easily get their heads around it.

The use of SAFES has exploded in Regulation CF offerings, both as a means for an early stage company to avoid having to deal with large numbers of shareholders, and to avoid the risk of inadvertently, or prematurely, becoming a fully reporting public company under current SEC rules.

Recently, SEC Commissioner Piwowar succinctly described the SAFE:

“The SAFE was first invented by Y Combinator, for use by early investors in a startup hoping to get a piece of the next “gazelle” – or even a unicorn. It was essentially, an option to acquire equity in the future, at a price, yet undetermined, pegged to a discount to a future institutional financing round, and usually with a cap on the company’s valuation.  A SAFE investor typically has no ability to realize any return on its investment until a future liquidity or financing event, such as a follow on institutional round, an IPO or an exit through a sale of the business.”

This has served its purpose for investment by a small group of sophisticated investors in startup enterprises, eliminating the need for time consuming negotiations over financing terms. However, as many have observed, it is not necessarily well suited for consumption by a large group of unsophisticated investors, particularly when issued by “slow growth” companies, often with no reasonable prospects for institutional financing, an IPO or a buy out – typical of the vast majority of Regulation CF issuers thus far. 

Adding to this potentially toxic investor brew – unlike the Y Combinator SAFE model, the SAFES touted by Regulation CF intermediaries vary significantly in their terms, from one platform to the next.  Although issuers can modify the templates, they rarely do – as this would require the assistance of a well trained securities lawyer – normally not in a startup’s budget.  The ones I have reviewed, proffered by three major Regulation CF platforms, though issuer friendly, are not a security where, as an investor, I would place my money without significant modifications.

As SEC Commissioner Piwowar recently remarked:

“Intermediaries face a real challenge in educating potential investors about this high-risk, complex, and non-standard security when the security itself is entitled ‘SAFE.’”

And as to issuer disclosure, a la the mandatory Form C, well let’s just say that more often than not issuers make no disclosure whatsoever about the unique risks of the SAFE security (Kudos, however, to issuers guided by iDisclose, a notable and welcome exception to the rule) – something DERA ought to take a closer look at in its next report.

Regulators Perceive a Problem With SAFEs, But Have Yet to Articulate Solutions

The proliferation of SAFEs under Regulation Crowdfunding has not gone unnoticed by the SEC. At an SEC-sponsored crowdfunding forum on February 28, 2017, Commissioner Kara Stein observed:

“These so-called SAFE securities are contractual derivatives. The issuer promises to give the investor stock upon the occurrence of a contingent future event. The event is typically linked to a subsequent valuation event, such as securing an additional round of financing, a company sale, or an initial public offering. However, many small and emerging businesses will never attain the subsequent valuation event. As a result, a retail investor is left with little more than the paper on which the contract is written.”

These same concerns were voiced by Commissioner Piwowar in a public address only two months later, describing the widespread use of SAFES under Regulation Crowdfunding a “concerning development.”

In this same address, Commissioner Piwowar appeared to suggest that the solution to the widespread proliferation of SAFES may lie with the Commission itself.

“As regulators, we also have a responsibility to ensure that our rules are functioning as intended and in an effective and efficient manner. We must engage in a constant process to obtain feedback as to how our rules are operating in practice. When we learn that there are widespread compliance challenges with a rule, we have a duty to fix the situation, particularly where investors may be adversely affected.”

With this I heartily concur. And, well – here is some “feedback,” and some proposed solutions for the Commission to take up at one of its next meetings, on the Agenda of the newly appointed SEC Chair Jay Clayton.

Looking to Solutions for a Safer Regulation Crowdfunding Marketplace

In a well written and insightful analysis of SAFES and Regulation Crowdfunding contained in a University of Virginia Law Review Article

The authors stated:

“.   .   . we believe that early market participants may be unintentionally sabotaging the crowdfunding experiment. Specifically, we believe that the forms of a relatively new startup-financing instrument, the simple agreement for future equity (“SAFE”), currently offered by crowdfunding portals such as WeFunder and Republic, contain terms that are likely to frustrate the ability of investors to share in the upside of successful crowdfunding companies. In other words, crowdfunding investors who purchase SAFEs may discover that these instruments are anything but.”

One of the possible solutions posed in the article, banning the use of SAFES altogether, is not one that I would embrace, and has been roundly criticized by my colleague, Amy Wan, in a piece she penned on Crowdfund Insider back in September 2016.

Ms. Wan, also being the forward thinker she is known to be, presented a solution, in the form of legislation introduced, but not yet law, known as the Fix Crowdfunding Act. The FCA addresses one of the root causes of the proliferation of SAFES in crowdfunding, the nightmare an issuer faces when having to deal with hundreds, even thousands, of shareholders – particularly when shareholder consent is needed, often the case with early stage companies. Or in Silicon Valley speak, the “cap table problem.”

The Fix Crowdfunding Act allows for the formation of “special purpose vehicles” (SPV’s), where the crowdfunding investors would invest through a single entity – whose sole mission was to invest in one crowdfunding issuer – and where shareholder decisions would be made by a single representative – who must also be a registered investment advisor.  And with the SPV, a multitude of crowdfunders on the issuer’s cap table would be replaced by a single shareholder-entity, the SPV.  Absent this legislation, this structure is unlawful under another federal securities law, the Investment Company Act of 1940.

Part of the Problem – and the Solution – is Within the Ambit of SEC Rulemaking

A “messy cap table” with hundreds or thousands of non-accredited investors presents other serious challenges – and risks – for some would be crowdfunding companies.

When a Regulation CF company completes its offering, it is tasked under the JOBS Act and SEC rules with making annual financial and non-financial disclosures, intended to be right-sized for the smallest of companies.

However, for the company expecting explosive growth following a Regulation CF offering, current SEC rules place a major, unnecessary obstacle in the way – one that the Commission can and should remove.

You see, when a crowdfunded company exceeds 500 non-accredited shareholders of record, and then goes on to have more than $25 million in total assets, under current SEC rules this triggers a requirement that this young, emerging company, become a fully reporting SEC company, subject to the same types of public filings made by mature, well capitalized public companies.

This SEC imposed trigger has undoubtedly scared off would be Regulation CF companies, many of a type which would likely be the most worthy of investment – high growth potential companies able to attract future institutional/venture capital, and who wish to avoid or delay becoming a publicly reporting company.  Why would an issuer take this risk of involuntarily becoming a fully reporting company when other less risky options are available – such as private placements which have no reporting obligations, initial or ongoing, no cap on the amount raised, etcetera, etcetera, etcetera.

And who does this disadvantage?  The non-accredited investor, generally excluded from private placements due to long standing SEC rules governing private placements.  The little investor currently gets the “leftovers,” so to speak, to sift through in Regulation CF offerings.

And even if the Fix Crowdfunding Act were to become law, not all companies will have or necessarily want SPV investors, simply as a way to circumvent this risk or otherwise.  SEC rulemaking to modify its rules triggering full reporting status – excluding crowdfunded securities from the 500 shareholder of record count – would be a simple fix – and undoubtedly end the proliferation of SAFES in the Regulation CF market place. With this simple fix, issuers could also find workarounds for going to hundreds of shareholders for consent – such as private contractual agreements for proxies on certain matters.

The Solution is an Easy Fix for the New SEC Commission

Under the Securities Exchange Act of 1934 the Commission retains virtually unfettered discretion to exempt issuers and securities from otherwise applicable rules governing when a company must become a fully reporting company.

The Commission ought to simply amend its rules to exclude from the current 500 non-accredited shareholder of record trigger securities issued in a Regulation CF offering.  This is not a novel concept. A similar route was followed by the Commission when it promulgated rules for Regulation A+ for larger, SEC-reviewed offerings.

And One Other Fix Needed – to Invigorate Regulation A+ Marketplace and Increase Quality Dealflow

I would urge our newly constituted SEC Commission, with Chair Clayton at the helm, to invite the folks at FINRA to one of its upcoming meetings.

You see, as both a stakeholder and an observer in the Regulation A+ marketplace, one of my biggest disappointments has been the relatively few number of deals which are sponsored by broker-dealers.

Apart from bringing investors to an offering, licensed broker-dealers serve an important function, especially with smaller, high-risk issuers.  They are required to perform an extensive due diligence review of the company and the offering terms before the deal sees the light of day – an important gatekeeping function which provides some quality filter on Regulation A offerings. In the current environment there is no legal requirement for a Reg A issuer to utilize a licensed broker-dealer, and often Reg A issuers will utilize an unlicensed third party Internet intermediary – or no intermediary at all.

FINRA also regulates the content of public advertising of its members’ offerings – requiring its broker-dealers to refrain from any public statements which are not “fair and balanced.”  The dangers presented to the public when an issuer goes it alone are most recently illustrated by a current Regulation A+ offering,  Yayyo, whose CNBC promotion, was the subject of recent and very skeptical national press. The ad was promptly pulled after receiving a flurry of unwanted, and unflattering press.  The promo, with its celebrity spokesperson, was perhaps, a good way to market a consumer product on late night TV at the ubiquitous price of $19.99, with order takers standing by. But this type of hyperbolic, unbalanced pitch has no place in the offer and sale of any kind of investment.

So why the low level of broker-dealer participation in Regulation A+ “mini-IPO’s?”

Yes, of course there is a learning curve with any new type of securities offering. But I believe a big part of the reason for low broker-dealer interest is the way FINRA has applied its broker compensation rules to these new offerings. Instead of allowing the heftier commissions for brokered private placements, FINRA is limiting broker compensation to the less generous rates for full blown IPO’s.  The industry chatter I have been hearing is that these FINRA limits on Regulation A+ offerings have discouraged many would be broker participants from entering the Reg A market place.  The reasons are not hard to fathom.

Reg A deals tend to be riskier for a broker, less likely to fund – and certainly not at the higher dollar levels typical of a traditional IPO. And Reg A offerings are not the “hot” offerings seen with some traditional IPO’s, where the offering is oversubscribed and the security trades sharply higher in the immediate after-market. For those who know this industry, they understand that in an IPO the big broker payday is from the “green shoe,” where the broker has the option of acquiring securities for its own account, at the offering price, exercisable in the weeks after the offering hits the market.

So please, Chair Clayton, if not a full Commission meeting, at least have a chat with your counterparts over at FINRA.  Yes, FINRA has done a wonderful job in the past year of seeking public comment on its rules. Maybe I missed this, but I have not seen this one on the public comment list.

Yes, NASAA may complain, as it has publicly done with abandoning the “tick size” rule.  They may argue that bigger broker commissions mean higher prices for investors.  But how’s it working out for that favorite restaurant down the street of yours that’s no longer in business – because it couldn’t raise its menu prices to keep up with rising costs?

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